Sunday, October 12, 2008

Willem Buiter, Professor of European Political Economy @ the London School of Economics and Political Science, submits following "rather specific" action plan to solve the financial crisis:

(1) Public guarantees of interbank lending between banks in different national jurisdictions. This could be implemented by national central banks acting as counterparty of last resort in the (unsecured) interbank markets.

(2) International agreement on limits on public guarantees for other bank liabilities and for liabilities of other highly leveraged institutions. This includes agreements on terms and conditions attached to such guarantees.

(3) International agreement on recapitalisation of banks with significant cross-border activities.

(4) Fiscal bail-outs of countries whose systemically important banks have a solvency gap that exceed the government’s fiscal capacity.

(5) International agreement on mandatory debt-to-equity conversions for banks and other highly leveraged institutions.

(6) International agreement on avoiding a moral hazard race to the bottom for deposit insurance through limits on deposit insurance (this is really as special case of (2)).

(7) International agreement on common access rules and common methods for valuing illiquid assets in different national TARP-like structures.

(8) International agreement to adhere rigorously to mark-to-market accounting and reporting principles and on common rules for relaxing regulatory requirements attached to marked-to-market valuations.

Buiter comes up with a great action plan, but I am not sure if it would solve the problem. In order to do just that first we have to understand what the problem is.Nouriel Roubini calls it the "mother of all bank runs", a run on the shadow banking system of over the counter derivative contracts called credit default swaps (CDS). The size of this unregulated market was $62 trillion at the end of 2007. It therefore by far exceeds all government measures combined.

Last Friday CDS contracts with bankrupt Lehman were auctioned at less than 10 cent on the dollar, which means that counterparty obligations are more than 90 cents on the dollar. Now everybody wants to get out and CDSs are sold at fire sale prices. This is eroding the capital of banks and drives them into bankruptcy. All the government actions combined cannot stop it because the capital injections are insufficient.

Instead of focusing only on capital injections we should also convene a global international banking conference, where CDS contracts will be mutually canceled. After all they have been agreed upon over the counter, it should be possible to cancel them the same way. The number of banks could be limited too, since only large banks are system relevant. Nevertheless every bank should be allowed to participate and CDS should be worked off contract by contract.

We all witnessed the carnage on the balance sheets of banks when subprime securitzed mortgage loans were sold at fire sale prices. The subprime market was $1.5 trillion. Now we are in the middle of face two, the selling of CDS contracts at fire sale prices. Only this time the market is about 50 times larger. Without global agreement on canceling this contracts the meltdown will continue.